What does an inverted yield curve mean to you?
You’ve heard the term inverted yield curve (IYC) mentioned many times in the media, even on the evening news. There’s a negative stigma attached to it, but like many people, you may not know what it actually means or how it might affect you. A yield curve is created on a chart by plotting treasury bills by maturity on the X axis and by yield on the Y axis. 1-year cash, 2-year cash, then 5-year cash, 10-year cash, and so on along the X axis in order of shortest to longest term. The long end of the yield curve starts with 10-year Treasury bills. Yield is labeled on the Y axis from zero and high from low to high. As you plot the yield and maturity of each cash, the plots should gradually increase with longer maturity dates. Shorter maturities generally have lower yields, and they increase as maturities get longer. Connecting the plots generates the visual yield curve. The yield curve helps investors visualize and measure the risk and potential rewards of investing in treasury bills.
Positive yield curves
The yield curve is used as a benchmark used by investors when comparing fixed income instruments beyond treasury bills, including government, corporate and municipal bonds and CDs. Yield curves have three shapes, a positive upward slope, a flat slope, and a negative inverted slope. A positive yield curve has an upward slope because shorter maturities have lower yields than longer maturities. This is because the risk increases with longer periods and therefore the reward must be commensurate. This is the most common and expected yield curve during times of economic growth. This can eventually lead to inflation causing higher interest rates.
Inverted Yield Curves
Inverted yield curves have decreasing negative slopes because shorter maturities have higher yields than longer maturities. They occur when investors expect an economic downturn because the risk is higher in the short term than in the long term. As investors seek safety in long-term bonds, yields rise for shorter maturities. As investors shift from short-term bonds to long-term bonds, yields reverse. Flat yield curves are the middle or transition stage when yield curves reverse from positive to negative and vice versa. Yield curve flattening occurs when long-term rates fall while short-term rates rise during reversals, which is an early signal of a reversal.
Impact of inverted yield curves
Inverted yield curves are like Mothman’s observations which are generally seen as a warning signal of an impending economic downturn that could lead to a recession. This was the case during the housing bubble and the financial collapse of 2007, the yield curve having inverted in 2006 before the recession. Past recessions show that an inverted yield curve signals a recession six to 36 months after the inversion. The yield curve briefly inverted in 2019, but the pandemic steepened quickly following the pandemic. Overall, the inverted yield curve resulted in signaling the last five recessions in 62 years from six months to three years. Critics argue that this is a coincidence, not a correlation, with the inevitability of economies going through booms followed by busts.
Yield Curve Distortion
The 2008 financial crisis spawned the era of quantitative easing in which the Federal Reserve “prints money” by buying long-term US Treasuries to stimulate growth (and the stock market). In doing so, it drives down yields on longer maturities, thereby inverting the yield curve in the process. Or if the Fed is selling long-dated Treasuries, why buy short-dated Treasuries to flatten and steepen the yield curve. Critics point out that this distortion caused by Fed intervention makes the inverted yield curve a less reliable indicator of recession.
How does this affect you?
Banks use the credit risk tempered yield curve to determine the rates they will charge you on loans. This will affect your credit card, car loan and mortgage payments. Since yield curves precede recessions and bear markets typically occur during recessions, an inverted yield curve can trigger a sell-off in the market as investors avoid risk and get into safety. long-term treasury bills. Many argue that this is self-fulfilling rather than correlated. However, the yield curve continues to deepen in 2022 as the Fed maintains a hawkish stance with its interest rate hikes